Home Refiance

- [voiceover] what iwant to do in this video is explain what a mortgage is. i think most of us have atleast a general sense of it, but even better than that,actually go into the numbers and understand a little bitof what you are actually doing

Home Refiance, when you're paying amortgage, what it's made up of and how much of it is interest versus how much of it isactually paying down the loan. let's just start with a little example.

let's say that thereis a house that i like. let's say that that is the house that i would like to purchase. it has a price tag of, let's say that i need to pay $500,000 to buy that house. this is the seller ofthe house right here. and they have a mustache. that's the seller of the house. i would like to buy it.

i would like to buy thehouse. this is me right here. and i've been able tosave up $125,000 dollars. i've been able to save up$125,000 but i would really like to live in that house so i go to a bank. i go to a bank, let me geta good color for a bank. that is the bank right there. and i say, "mr. bank, can you lend me "the rest of the amounti need for that house?" which is essentially $375,000.

i'm putting 25% down.this number right here, that is 25% of $500,000. so i ask the bank, "can ihave a loan for the balance? can i have $375,000 loan?" and the bank says, "sure.you seem like a nice guy "with a good job whohas good credit rating. "i will give you the loan but while you're paying off the loan you can'thave the title of that house. "we have to have that title of the house

"and once you pay off the loan, "we're going to give youthe title of the house." what's gonna happen here isthe loan is gonna go to me, so it's $375,000. $375,000 loan. then i can go and buy the house. i'm gonna give the total $500,000, $500,000 to the seller of the house, and i'll actually moveinto the house myself,

assuming i'm using itfor my own residence. but the title of the house, the document that says who actually owns the house. this is the home title. this is the title of the house. home title. it will not go to me.it will go to the bank. the home title will go from the seller, or maybe even the seller's bank,

because maybe they haven'tpaid off their mortgage. it will go to the bankthat i'm borrowing from. this transferring of thetitle to secure a loan. when i say "secure aloan," i'm saying i need to give something to thelender in case i don't pay back the loan or if i just disappear. this is the security right here. that is technically what a mortgage is. this pledging of the titleas the security for the loan,

that's what a mortgage is. it actually comes from old french. mort means dead, andthe gage means pledge. i'm 100% sure i'm mispronouncing it, but it comes from dead pledge because i'm pledging itnow but that pledge will eventually die once i pay off the loan. once i pay off the loan thispledge of the title to the bank will die and it will come back to me.

that's why it's called adead pledge, or a mortgage. and probably because itcomes from old french is the reason we don't saymort-gage, we say mortgage. but anyway, this is alittle bit technical, but normally when peoplerefer to a mortgage they're really referringto the loan itself. they're really referringto the mortgage loan. what i want to do inthe rest of this video is use a screenshot froma spreadsheet i made

to actually show you the math, or actually show you what yourmortgage payment is going to. you can download thisspreadsheet at khanacademy, khanacademy.org/downloads/mortgagecalculator or actually, even better, justgo to the downloads folder and on your web browseryou'll see a bunch of files, and it will be the filecalled mortgagecalculator, mortgagecalculator.xlsx. it's a microsoft 2007 format.

just go to this url, thenyou'll see all the files there and you can just download this file if you want to play with it. what it does here, in thiskind of dark brown color, these are the assumptionsthat you can input and then you can change thesecells in your spreadsheet without breaking the whole spreadsheet. here i've assumed a 5.5% interest rate. i'm buying a $500,000 home.

it's a 25% down payment, that's the $125,000 that i had saved up, that i talked about right over there. and then the loan amount. well, i have 125, i'mgonna have to borrow 375, it calculates it for us. and then i'm gonna get apretty plain vanilla loan. this is gonna be a 30 year. when i say term in years, thisis how long the loan is for.

so 30 years. it's gonna be a 30 yearfixed-rate mortgage. fixed rate, which means theinterest rate won't change. we'll talk about that a little bit. this 5.5% that i'm payingon the money that i borrowed will not change over thecourse of the 30 years. we will see that the amount i've borrowed changes as i pay down some of the loan. this little tax rate that i have here,

this is to actually figureout what is the tax savings of the interest deduction on my loan. we'll talk about that in a second, you can ignore it for now. then these other thingsthat aren't in brown, you shouldn't mess with these if you actually do open up thespreadsheet yourself. these are automatically calculated. this right here is amonthly interest rate.

so it's literally theannual interest rate, 5.5%, divided by 12. and most mortgage loans arecompounded on a monthly basis so at the end of every monththey see how much money you owe and they will charge you this much interest on that for the month. now given all of these assumptions, there's a little bit ofbehind-the-scenes math, and in a future video imight actually show you

how to calculate what theactual mortgage payment is. it's actually a prettyinteresting problem. but for a $500,000 loan--well, a $500,000 house, a $375,000 loan over 30 yearsat a 5.5% interest rate, my mortgage payment isgoing to be roughly $2,100. right when i bought the house, i want to introduce alittle bit of vocabulary, and we've talked about thisin some of the other videos. there's a asset in questionright here, it's called a house.

and we're assuming it's worth $500,000. we're assuming it's worth$500,000. that is an asset. it's an asset because itgives you future benefit; the future benefit ofbeing able to live in it. now there's a liabilityagainst that asset, that's the mortgage loan. that's a $375,000 liability. $375,000 loan or debt. if this was your balance sheet,

if this was all of your assetsand this is all of your debt, and you were essentiallyto sell the assets and pay off the debt, if you sell the house you get the title, you can get the money, thenyou pay it back to the bank. well actually, it doesn'tnecessarily go into that order but i won't get too technical. but if you were to unwindthis transaction immediately after doing it, then youwould have a $500,000 house,

you'd pay off your $375,000 in debt, and you would get, inyour pocket, $125,000, which is exactly what youroriginal down payment was. but this is your equity. the reason why i'm pointing it out now is, in this video i'm notgonna assume anything about the house price,whether it goes up or down, we're assuming it's constant. but you could not assume it's constant

and play with thespreadsheet a little bit. but i'm introducing thisbecause as we pay down the debt this number's going to get smaller. so this number is getting smaller. let's say at some pointthis is only 300,000. then my equity is going to get bigger. so you could do equity ishow much value you have after you pay off the debt for your house. if you were to sell thehouse, pay off the debt,

what do you have left over for yourself. this is the real wealth in thehouse, this is what you own. wealth in house, or theactual what the owner has. what i've done here is-- actually before i get tothe chart let me actually show you how i calculate the chart. i do this over the course of30 years, and it goes by month. so you can imagine that there's actually 360 rows here in the actual spreadsheet,

and you'll see that ifyou go and open it up. but i just want to show you what i did. on month 0, which i don't showhere, you borrow $375,000. now, over the course of that month they're going to charge you .46% interest. remember, that was 5.5% divided by 12. .46% interest on $375,000 is $1,718.75. so i haven't made anymortgage payments yet. i've borrowed 375,000.

this much interest essentiallygot built up on top of that, it got accrued. so now before i've paidany of my payments, instead of owing 375,000 atthe end of the first month, i owe $376,718. now, i'm a good guy, i'm notgonna default on my mortgage so i make that first mortgage payment that we calculated right over here. after i make that paymentthen i'm essentially,

what's my loan balanceafter making that payment? well, this was before making the payment, so you subtract the payment from it. this is my loan balance after the payment. now this right here, thelittle asterisk here, this is my equity now. so remember, i startedwith $125,000 of equity. after paying one loan balance,after my first payment, i now have $125,410 in equity,

so my equity has gone up by exactly $410. now you're probably saying,"gee. i made a $2,000 payment, "roughly a $2,000 payment, "and my equity only went up by $410 "shouldn't this debthave gone down by $2,000 "and my equity have gone up by $2,000?" and the answer is no because you had to pay all of this interest. so at the very beginning, your payment,

your $2,000 payment, is mostly interest. only $410 of it is principal. so as your loan balance goes down you're going to pay less interest here, so each of your payments are going to be more weighted towards principal, and less weighted towards interest. and then to figure out the next line, this interest accrued right here,

i took your loan balanceexiting the last month, multiplied that times .46%. you get this new interest accrued. this is your new pre-payment balance. i pay my mortgage again.this is my new loan balance. and notice, already by monthtwo, $2 more went to principal. and $2 less went to interest. and over the course of 360months you're going to see that it's an actual, sizable difference,

and that's what thischart shows us right here. this is the interestand principal portions of our mortgage payment. so this entire heightright here, this is-- let me scroll down a little bit. this is by month. so thisentire height, you notice, this is exactly our mortgagepayment, this $2,129. now, on that very first monthyou saw that of my $2,100, only $400 of it, this is the $400.

only $400 of it went toactually pay down the principal, the actual loan amount. the rest of it went to pay down interest, the interest for that month. most of it went for theinterest of the month. but as i start paying down the loan, as the loan balance getssmaller and smaller, each of my payments, there'sless interest to pay. let me do a better color than that.

there's less interest. we goout here, this is month 198, over there that last monththere was less interest, so more of my $2,100 actuallygoes to pay off the loan until we get all the way to month 360. you can see this inthe actual spreadsheet. at month 360 my final payment is all going to pay off the principal. very little, if anything,of that is interest. now, the last thing i wantto talk about in this video,

without making it too long, is this idea of a interest tax deduction. a lot of times you'll hearfinancial planners or realtors tell you the benefit of buying your house is it has tax advantages, and it does. your interest is tax deductible. your interest, not your whole payment. i want to be very clearwhat deductible means. first let's talk aboutwhat the interest means.

this whole time over 30 yearsi am paying $2,100 a month, or $2129.21 a month. now the beginning, alot of that is interest. so on month one, 1,700of that was interest. that $1,700 is tax deductible. as we go further and further, each month i get smaller andsmaller tax deductible portion of my actual mortgage payment. out here the tax deductionis actually very small,

as i'm getting ready topay off my entire mortgage and get the title of my house. i want to be very clear on this notion of what tax deductible even means, because i think it ismisunderstood very often. let's say in one yeari paid, i don't know, i'm gonna make up a number, i didn't calculate it on the spreadsheet. let's say in year one ipay $10,000 in interest.

10,000 in interest. remember, my actual paymentswill be higher than that because some of my payments went to actually paying down the loan. but let's say 10,000 went to interest. and let's say before this, let's say before thisi was making 100,000, let's put the loan aside. let's say i was making $100,000 a year,

and let's say i was payingroughly 35% on that 100,000. i won't go into the whole tax structure and the differentbrackets and all of that. let's say if i didn't have this mortgage i would pay 35% taxes, which would be about $35,000in taxes for that year. this is just a rough estimate. when you say that $10,000is tax deductible, the interest is tax deductible,

that does not mean that i canjust take it from the $35,000 that i would have normallyowed and only pay 25,000. what it means is i can deductthis amount from my income. when i tell the irs howmuch did i make this year, instead of saying i made $100,000,i say that i made $90,000 because i was able to deduct this, not directly from my taxes, i was able to deduct it from my income. so now if i only made $90,000 --

and this is, i'm doing agross oversimplification of how taxes actually get calculated -- and i pay 35% of that, let'sget the calculator out. let's get the calculator. so 90 times .35 is equal to 31,500. so this will be equal to $31,500. $31,500. off of a 10,000 deduction,$10,000 of deductible interest, i essentially saved $3,500.i did not save $10,000.

another way to think about it, if i paid 10,000 interestand my tax rate is 35%, i'm gonna save 35% ofthis in actual taxes. this is what people meanwhen they say deductible. you're deducting it from the income that you report to the irs. if there's something thatyou could take straight from your taxes, that'scalled a tax credit. if there was some specialthing that you could actually

deduct it straight from yourtaxes, that's a tax credit. but a deduction justtakes it from your income. on this spreadsheet ijust want to show you that i actually calculated, in that month, how much of a tax deduction do you get. so for example, just offof the first month you paid $1,700 in interest of your$2,100 mortgage payment, so 35% of that, and i got 35%as one of your assumptions, 35% of $1,700, i will save$600 in taxes on that month.

so roughly over thecourse of the first year i'm gonna save about $7,000 in taxes, so that's nothing to sneeze at. anyway, hopefully you found this helpful and i encourage you togo to that spreadsheet, and play with the assumptions, only the assumptions in this brown color unless you really know whatyou're doing with a spreadsheet, and you can see how thisactually changes based on

different interest rates,different loan amounts, different down payments, different terms. different tax rates, that will actually change the tax savings, and you can play aroundwith the different types of fixed mortgages on this spreadsheet.

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